2009 Forecast Episode II: Deflation Strikes Back

This is Part II of a indeterminate series on the Accrued Interest 2009 Forecast. Here I'll focus on general interest rates and Treasury Bonds.


The question on many lips is are Treasury bonds a bubble? I've already said that fighting deflation will be the major theme of 2009. Deflation will remain the primary concern of the Fed until housing prices start to recover. I don't see that happening until 2010. Until housing prices start to rise, we'll see persistently poor final consumer demand. This in turn keeps the velocity of money low and thus the money supply contracting.


I have a very simplistic mental model for Treasury rates. Real interest rates should reflect the opportunity cost of money. Thus a short-term Treasury rate should be the opportunity cost plus an inflation premium. Longer-term rates should reflect both opportunity cost, inflation, and a term premium. When economic growth is weak, opportunities are less, and thus interest rates should fall.


If we have negative inflation, then short-term Treasury rates should be extremely low. Near zero makes sense for T-Bills (although negative yields is questionable at best). Less than 1% makes sense for the 2-year. So I see no bubble on the front end of the Treasury curve. Not that there is a ton of upside on the 2-year at 0.75%, but could it go to 0.50%? Sure.


Longer Treasury bonds are the better bubble candidates. One might be able to argue that in the short term, both growth and inflation will be negative, thus the equilibrium nominal short-term rate should probably be negative. But longer term, we'll eventually have both growth and inflation, and thus long-term Treasuries should not be approaching Japanese-like levels.

So when the 10-year was pushing 2%, it felt bubbly. But still I resist the bubble label. To me, Treasury rates are clearly below "fair value" but given the extreme liquidity and economic circumstances, I doubt the 10-year can move above 3% until at least 4Q 2009. I think long-term Treasuries remain over-valued until its obvious that inflation is going to eventually become a problem.

What about Treasury supply you ask? Won't the massive debt load eventually push rates much higher? While acknowledging that supply is an obvious negative for prices always and everywhere, as it is, Treasury supply is clearly not overwhelming demand. The 3-year and 10-year auctions from last week went quite well.

Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't.

Eventually, the Fed's programs will result in much higher inflation, and thus Treasury rates will rise substantially. But I think this is a year or more away, too far away to recommend a short.

The problem for real money investors is that Treasury yields are so low, that you pretty much have to own something else. The yield advantage on short-term Agencies versus short-term Treasuries is so large that there isn't any logical scenario where the Treasury outperforms. Therefore I'm playing this by remaining underweight Treasury bonds, but owning stuff that can appreciate if Treasury rates fall. This includes bullet agencies, and some very high quality corporates.